Can You Withdraw From Your Life Insurance?
Understand the options for accessing your life insurance policy's inherent worth before its death benefit payout, and their overall impact.
Life insurance provides a financial safety net, offering a death benefit to beneficiaries upon the policyholder’s passing. While its primary purpose is protection, certain policies also serve as a financial resource during the policyholder’s lifetime. These policies accumulate a value that can be accessed for various needs, offering liquidity. Understanding how to access these funds and the implications of doing so is important for policyholders.
Understanding Cash Value Life Insurance
A unique feature of certain life insurance policies is the accumulation of cash value, a savings component within the policy. A portion of each premium payment contributes to this cash value, allowing it to grow over time. This growth often occurs on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered.
Cash value accumulation varies by permanent life insurance policy type. Whole life policies typically offer a guaranteed fixed interest rate for predictable growth. Universal life policies have cash value growth sensitive to current interest rates, often with a guaranteed minimum rate. Variable universal life policies invest funds into sub-accounts, similar to mutual funds, so their cash value fluctuates based on investment performance. Term life insurance, designed solely for coverage over a specific period, does not build cash value and offers no access options.
Policy Loans
One method of accessing funds from a cash value life insurance policy is by taking a policy loan. This is an advance from the insurer, with the policy’s accumulated cash value serving as collateral. The policy remains in force, and the cash value continues to grow, though the loan amount reduces the available cash value.
Interest accrues on the outstanding loan balance, and policy loan interest rates typically range from 5% to 8%. Policyholders have flexibility in repayment; there is no strict schedule, and they can repay principal and interest or allow interest to accrue. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the policyholder’s death. If the loan balance grows too large and exceeds the policy’s cash value, it can lead to the policy lapsing and terminating coverage.
Cash Withdrawals
Directly withdrawing cash from a life insurance policy’s cash value is another way to access funds. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and death benefit. The withdrawn amount does not need to be repaid to the insurer.
When a policyholder makes a cash withdrawal, the amount is considered a return of premiums paid, known as the cost basis. Withdrawals up to this cost basis are generally tax-free. Any amount withdrawn exceeding the cost basis, representing the policy’s earnings, becomes taxable as ordinary income. Large withdrawals can significantly deplete the policy’s cash value, potentially leading to the policy lapsing if the remaining value is insufficient to cover ongoing charges. This could result in coverage loss and potential tax liabilities on any gains.
Surrendering Your Policy
Surrendering a life insurance policy terminates the policy, allowing access to its cash value. When a policy is surrendered, coverage ceases completely, and the death benefit is forfeited. In exchange, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges.
Surrender charges are fees imposed by the insurance company for early termination. These charges are higher in the initial years of the policy, gradually decreasing over a period before phasing out. The finality of surrendering means losing the insurance coverage and protection the policy provided. This option is generally considered when coverage is no longer needed or other financial avenues are exhausted.
Tax Considerations
Understanding the tax implications is important when accessing funds from life insurance policies. Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid (cost basis) can become taxable as ordinary income. Interest accrued on policy loans is generally not tax-deductible.
For cash withdrawals, taxation follows a “first-in, first-out” rule. Withdrawals are considered a return of the premiums paid (cost basis) first. Amounts withdrawn up to the total premiums paid are typically tax-free. Any portion exceeding this cost basis, representing the policy’s earnings, is subject to taxation as ordinary income.
When a policy is surrendered, any amount received greater than the total premiums paid (cost basis) is considered a taxable gain. This gain is taxed as ordinary income, not capital gains, as surrender is viewed as a contract termination. The insurer may issue a Form 1099-R if the cash surrender value exceeds the premiums paid, indicating the taxable portion. These tax consequences can significantly impact the net amount received from accessing life insurance policy funds.